Surprises & Policies - Weekly Blog # 660

 

Mike Lipper’s Monday Morning Musings

Surprises & Policies

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                           

                     

Surprises

One of the most curious things about most humans is that they are surprised by surprises. Perhaps it is my Marine Corps training, being a student of history, or just having a contrarian streak, but I always expect surprises. Without knowing the details, I know that I will live and operate in periods of uncertainty. Below are two lists: Elements of uncertainties and reactions.

Surprises                        Reactions

Prices (Inflation)               Ignore (As long as Possible) 

Quality (Improvements?)          Go with the flow 

People (Unexpected behavior)     Resist

Taxes (Words worse than rates)   Attempt to escape

Current Surprises

My friend Byron Wein publishes a list of forthcoming surprises each year. Below are three surprises that are already known but not being considered by most investors and their advisors. Thus, their lack of reaction is the real surprise.

Rising Prices (Inflation)

For several weeks I have been noting the almost parabolic price increase in the JOC-ECRI Industrial Price Index. This week it reached +23.80% compared to a year ago. This phenomenon is supported by the mid December price of coiled sheet steel, which was $900/ton compared to $700/ton in mid-November. The price of Aluminum is nearing its two-year high. (With Coke Cola cutting the number of brands it sells in half, they are likely to try to pass on the increased costs of aluminum cans to consumers. An example of inflation at the supermarket level) In Asia there is a major shortage of shipping containers for exports. (I assume that means the rental price of shipping containers is up significantly.)

Many top-down thinkers in Washington and in the securities markets believe that central governments and their agencies can control their economies, exemplified by the following 2017 quote:

“Would I say there will never, ever be another financial crisis? Probably that would be going too far. But I do think we’re much safer, and I hope that it will not be in our lifetimes, and I don’t believe it will be” 

This was said by Janet Yellen and I believe it was part of her effort to be reappointed Chair of the Federal Reserve. Let’s hope in her new post she has learned to have more respect for forces she does not control.

The third surprise is the not much discussed probable immunity to COVID-19 after receiving the vaccine. Because of the newness of our collective experiences, the most learned of medical experts say there may be a 5-7 month immunity. Let us hope they are being conservative; however, even doubling the initial estimate suggests a very different world than most are expecting.

I am not suggesting I can make intelligent guesses as to how these three surprises will work out, but I am noting that these along with other uncertainties need to be considered in making day-to-day investment and other decisions.

Where Are We?

Far too many military and business battles were lost when one of the combatants used out of date positioning. As I cannot avoid being a global consumer and investor, I must look at both the US and other markets for our clients. Because we invest in mutual funds for our clients, we pay a great deal of attention to their results. Again, somewhat surprising is that various market pundits seem to be unaware of two current relationships.

Each week I review fund performance for numerous periods, including the 1, 4, 13, 52-week and year-to-date period results, which are compared with various equity asset allocations. While the average S&P 500 index fund has produced positive results in each of those time periods, they have underperformed the average US Diversified Equity fund, the average Sector Equity fund, and the average World Equity fund. (This has not been the case for longer periods.)

What has caused this change? The data gives us a clue. The popular way to display results is asset weighted. We also review performance averages that are not asset weighted and include the median fund’s performance. What we discovered for large-cap, medium-cap, and small-caps is that larger funds are doing better than their peers in almost every period. Why is that? Larger funds tend to have lower costs and often have more aggressive portfolios. Advisors and salespeople find that performance momentum makes an easier sale than a belief in different leadership over the next market period, which is less risky due to current performance leaders often being more volatile.

Another example of it being beneficial to pay attention to size is in commodities. The number of contracts by large speculators, commercial hedgers, and small traders are tabulated each week and large speculators are often successful. In the latest week, the aggregate large speculator reduced very large long holdings, except for positions in gold, silver, T bonds, and the Yen. This seems to indicate that speculators are betting on non-currency related inflation. A few portfolio managers, while bullish on their stock portfolios for 2021, believe there could be as much as a 10% drop in their stock portfolios in the first part of the year. (This may be related to concerns over the new administration having difficulty getting their program started.)

US vs. the Rest of the World

Our economy and stock market structure are different than the Rest-Of-The World (ROW). The following tables highlight key differences:

        GDP % of World Trade      Market Cap % of World

China            19%                        9%

US               16%                       44%

ROW              51%                       30%

                           S&P 500     MSCI World

Information Technology        26%          21%

Financials                    10%          13%

The Wisdom of Charlie Munger

One of the highlights of Berkshire Hathaway’s (*) annual meeting are the brilliantly phrased but somewhat laconic comments to questions that Warren Buffett spends too much time discussing. Charlie, a student at Caltech while he was in the Army Air Force during WWII, sat for a zoom interview for Caltech Associates. The following is my edited review of his 22 comments. (I will be pleased to send his full comments if desired.)

(*) Position held in our private financial services fund and personal accounts.

Selectively edited comments as follows:

1. Avoid being stupid consistently rather than trying to be very intelligent.
2. Technology is a killer as well as an opportunity.
3. American companies are like biology, all individuals die as do all species, it is just a question of time.
4. I try to keep things as simple and fundamental as I can
5. A successful life requires experiencing some difficult things that go wrong.
6. We are in unchartered waters regarding the rate we are printing money.
7. “Who would have guessed a bunch of communist Chinese run by one party would have the best economic record the world has ever seen.”
8. “I don’t think Caltech can make great investors out of most people.” Great investors, like great chess players, are born to be in the game.
9. “You have to know a lot, but partly it’s temperament, deferred gratification (willingness to wait); a combination of patience and aggression. Know what you don’t know”
10. One needs to be fanatical to succeed.

Question: Which of Charlie’s statements do you agree or disagree with?    

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2020/12/searching-for-surprises-weekly-blog-659.html

https://mikelipper.blogspot.com/2020/12/an-investment-dilemma-with-possible.html

https://mikelipper.blogspot.com/2020/11/mike-lippers-monday-morning-musings_29.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Janet Yellen Could be Right, If……

Premise

Janet Yellen, Chair of the US Federal Reserve Board of Governors, has said she does not expect a 2007-2009 financial crisis in her lifetime. For many reasons we hope that she has a long life. One of the lessons learned from lots of sports, including horse racing, and applied to business, portfolio management, and life in general is to be conscious of what could go wrong. If you will “the known unknowns” as well as making some allowance for “the unknown unknowns.” 

As an investment fiduciary I feel it is essential that one develops an appreciation for the odds that Ms. Yellen may be right.

What Causes Crises?

Major financial crises typically have both preliminary causes and a galvanizing event. The preliminary causes are relatively easily to spot, often by looking in a mirror. The event is often the unintended consequence to an action that forces many to brutally re-examine an intellectual or emotional structure in which we had total faith, that suddenly is found wanting.

Underlying Causes

The first cause is the belief in the inevitability of a pre-determined future. The growing enthusiasm for this belief overrides all past cautions. Because we all believe that we should be richer than we are, we will borrow to multiply our stake in the inevitable “goody.”  Often people and institutions look to borrow from any available source including surreptitiously from others without their notice... embezzlement. Thus, the essential second underlying cause for  crises is leverage. (For my mathematical readers- Enthusiasm in the “inevitable” times expanding use of “cheap” leverage = precursor of crisis.)

Where Are We Today?

Chair Yellen can not identify any major causes for concerns. She is right at the moment. Focusing on my continuing analysis of the global mutual fund business, I see some potential worries.

Are Equities About to Take Off?

One of the reasons that mutual fund performance is so often quoted by media, academics, and even government officials is that the data is quite accurate and rapidly and relatively available. I have been following these numbers for fifty years. This how I start to view the movements in the marketplace. On Friday we finished the first half of 2017. While the data is preliminary and subject to minor modification, it is instructive. There are at least nine investment objective averages producing double digit returns for the first half. (A copy of the list is available by contacting me. The leading investment objective is the Health & Biotechnology average of +18.46%)  Without dividends both the Dow Jones Industrial Average and the S&P500 were up 8% and using the Vanguard S&P 500 Index fund’s total reinvested return was 9.3% as a rough guide to the market.

In terms of our analysis, the key point: if the fund and general market performance produced high single digit gains in the first half, is it a reflection of growing enthusiasm which is relatively higher than the current sales, operating earnings, earnings per share or dividend growth? Remember that most institutions such as pensions and endowments have a targeted goal of between 4 and 9% for the year. The biggest gains were experienced by Growth rather than Value-oriented funds. Growth enthusiasts tend to be more future-oriented than value investors who are basically betting on correcting mis-priced securities. Either the markets are now premature in discounting future growth or will be in the future. Thus, we may begin to exhibit one of the standard precursr to a crisis.

Could Fixed Income be a Trigger?

The thirst for income is a global phenomenon to pay current or future bills. Almost everywhere that has a sizable Mutual Fund marketplace, money is pouring into bond funds at the retail level and into other credit instrument funds at the institutional level. What makes this concerning is the general market perception that interest rates will rise, and if things go wrong the rise could be significant. While Fixed Income investors typically focus on yields on purchase price, they are often shocked when they sell at prices below their initial purchase price. At some point at least the institutional investors will look at their investments on a total return basis incorporating current prices which could be materially lower due to interest rates rising. Future prices could be hurt by various trading entities like hedge funds being forced to meet collateral calls as their Fixed Income holdings are marked down to a declining market. My own suspicion is that the two segments which are most exposed to high leverage is government issued paper and credit instruments.

Archduke Accident Replay

Popular beliefs hold that World War I was begun as an outgrowth of the murder of the popular Archduke Franz Ferdinand of Austria on an automobile route in Sarajevo that had been changed due to security precautions from an incident earlier that day. The change was ordered without telling the chauffer.  The sad event set in motion countries that were already preparing for war and forced their allies to come to their aid. Often the trigger events are caused by an unintended consequence of a well intentioned act, often by some force within the government. Usually the forces that trigger the consequences have a much too narrow of a view of their impact. Allow me to suggest a hypothetical and probably improbable series of events.

Government officials and media pundits look at mutual funds as products with a sole goal of producing a higher return than some other measure. They fail to understand the history of the fund business. Mutual Funds started as a way to mobilize existing savings (usually on deposit) into long-term investing. To convince savers to part with some of their savings was not a simple exercise of giving the reluctant saver enjoying a level of security something to read. The sales process often took a number of sessions. The global fund business was a financial service activity not a financial product producer. Perhaps the key value of these financial services is not just the initial purchase, but subsequent purchases. Probably the greatest value during periods of scary market declines is urging the investor to stay invested. Finally, the process permits and encourages partial withdrawals and perhaps some switching into more appropriately aged investments. All of these services need to be available everyday and often in aggregate, cost more than the pure investment expenses. In recognition of these needs many fund distributors and allocators have styled themselves as wealth managers.

The UK’s Financial Conduct Authority is complaining that UK funds are not competitive enough. They want competition based on a single fee covering all the holder’s costs and performance. (They are not focusing that in many cases the services aspects of the fund business are equally or more important to the holder than fees and performance.) We have in the past seen similar naivety occasionally in the US. Some similar concerns had been expressed in the EU’s MiFid rules.

What Could Go Wrong?

For the moment assume that this type of thinking becomes popular in many countries, sales people and to some degree, service people will leave the fund business and migrate to more expensive products and services like hedge funds, private equity, venture capital, real estate, or “investment art.” There is some chance that the returns will be below mutual funds. Where this could create a large problem for various governments is that the growing retirement capital deficit is expanding and there will be pressure on taxpayers to fill the gap at the expense of other government services. Expanded government services will lead to higher inflation as the government will have to borrow more to pay its bills. Or taxes will rise which can in and of itself cause a financial crisis as taxpayers rapidly change their investing status.

What Are the Odds that Janet Yellen is Correct?

At the track regular horse players understand that in spite of all their considerable handicapping (analyzing) skills there is something called “racing luck.” Things happen that are the providence of the “unknown unknowns.” Ms. Yellen could luck out and there won’t be a financial crisis the rest of her life. 

For my responsibilities I am prepared to have to deal with some or more of these. I am growing particularly nervous over the next 18 months as governments that in general have a record of creating unintended impacts cope.  

Both the US and India are early in redefining their tax structure, France is going to attempt to become competitive through labor reform, China is restructuring economically and financially, and there is the little matter of Brexit.

One may need good advice now more than just faith that there won’t be any crises.        

__________

Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Mostly Positive Adjustments for Investors

Introduction

In last week’s post I mentioned one of the slogans used in the US Marine Corps, “Adapt, Improvise, and Overcome.” As today, November 10^th is the 238^th birthday of The Corps, I was thinking of all the adjustments it has had to make to become the nation’s premier fighting force. Though The Corps can handle almost any mission assigned to it, much of the slogan has to do with overcoming the rigidities imposed within itself and the US Defense establishment. I wonder whether Pope Francis is using a similar approach as he tries to adjust the behavior of the Roman Catholic Church, which could have impacts on many other organized religions.

Less cosmically, while painful in some cases, we are seeing a number of current adjustments that are subtly or perhaps not so subtly adjusting investment thinking as outlined below.

Lessons from the Twitter IPO

Twitter with the help of its lead underwriter Goldman Sachs^* had a successful launch of its IPO. While they did raise the price of the offering several times similar to Facebook, they did not adjust the number of shares being offered as Facebook did. The NYSE, the venue for the aftermarket, went through exacting trials under stressed conditions that NASDAQ^* did not with Facebook. The President could have learned a lot from the Twitter launch and adjusted his attempts to re-launch a somewhat more successful Obamacare.

A possible lesson to be feared

In a syndicated column by George F. Will entitled “The Enigma of Janet Yellen,”  the author  was concerned that by past experience and training, Ms. Yellen has been amenable to penalize savers to benefit equity owners around the world. He fears that in the absence of fiscal policy leadership, monetary policy led by the Fed is going to in effect, become the conscience of the government, and lead to adjusting our social priorities through the use of various monetary devices. If Mr. Will’s concerns are realized, the rate of inflation will rise and the dollar may shrink.

Unwinding of the 4% rule.

For many years’ wealth managers within or outside of trust departments have believed that a 4% withdrawal rate during retirement was possible without destroying the capital base. Today, based on the current low interest rates, some careful advisors are more comfortable with 3%, and T. Rowe Price^* believes 2.8% is more prudent. If these lower numbers are to be believed, spending and saving efforts will need to be adjusted. A similar exercise is needed for a number of endowment and foundation boards to contemplate.

Liberal Arts needs to be liberated

Currently a significant number of liberal arts colleges are facing declining enrollments, rising expenses and less than great returns on their too small endowments. Part of their problem is that often these organizations are governed with a high level of rigidity. Even in government, during periods of stress high-priced workers can be laid off. Granting tenure in higher education is often a one-way street, in that after being granted it, the tenured ones can stay employed as long as they want regardless of their productivity. 

One of the fields of study that should be examined by the payers of college tuitions is Macroeconomics. Robert Shiller, a 2013 Nobel laureate wrote a blog published by the Guardian entitled, “Is Economics a Science?”  He properly questions whether it is a science like Physics. He accurately says that the study of Economics has to do with policy. I suspect that is how this course is taught which could have some benefit to Political Science majors whose aim is the Presidency or slightly lower. On the other hand, Microeconomics introduces some techniques which could be useful to both consumers and producers. In my particular case the focus on price-setting with different degrees of inelastic supply and demand was useful in my business and investment career. What I am suggesting is that the rigidities found in much of the non-profit world need to go through serious adjustments and that will happen whether the occupants of the various ivory towers like it or not.

Investment thinking is being adjusted

All investment organizations are being caught in a pincer movement of lower investment returns in equity, debt, commodities, derivatives and cash concurrent with rising expenses for technology, compliance, marketing, and keeping their good people from going entrepreneurial either directly or to smaller shops, such as hedge funds. In this light it is interesting that Goldman Sachs^* will no longer produce research that is based on “growth at a reasonable price.” This is a policy that worked well in the mutual fund business for many years. In his leadership days at Fidelity Magellan, Peter Lynch was a major proponent of this strategy. In Peter’s search for good investments he found a large number of companies who were growing, not with a high growth rate but who were selling at prices that did not presume a continuation of their growth rate.

How are we are adjusting?

The first thing I do is look under the hood of various labeled classifications to see the spread of options that have been grouped under a simple label like growth or large cap. While it is useful to know how a manager performs relative to his peers under varying conditions, markets are not two dimensional up vs. down, most of the time they are in some form of equilibrium. The more you study people, the more different they appear to be. This is why an All-Star team picking the best player for each position often does not do well against a team of good players that has played together benefitting from natural leadership within the group.

I am looking to add a new fund to our portfolios. My key concern is whether the fund being examined, which is in a particular market phase, will add or subtract to the results of the existing portfolio.

One of the adjustments that I am making as I move away from labels is to look for good, understandable managers in broad categories. That is why I now group equity managers for my purposes under the banner of “equity exposure.” Because of the dynamic changes in the world’s intellectual leadership, I expect that the rate of adjustments will accelerate. I need to pay attention to these changes as they creep over the various time horizons that we must accommodate.

How do you expect to adjust to the future? 

^*Owned personally, by my private financial services fund, or both.

_______________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com .

Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.